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Chapter 20 Economic Growth and Rising Living Standards 1 Economic Growth • What determines the potential output? – Labor productivity or Productivity Amount of output average worker can produce in an hour – Average hours of labor Number of hours average worker spends at the job – Labor force participation rate (LFPR) Fraction of population that wants to work – Size of population 2 What Determines the Potential Output? • Labor productivity Total real output Output per hour Total hours of labor 3 What Determines the Potential Output? • Average hours of labor Average hours Total hours of labor Labor force 4 What Determines the Potential Output? • Labor force participation rate (LFPR) Labor force LFPR Population 5 What Determines the Potential Output? • Breaking down the total output Total output Total hours of labor Labor force Total output Population Total hours of labor Labor force Population Total output Labor productivi ty Aeverage hours LFPR Population 6 What Determines the Potential Output? • Review of some linear algebra If Z = X ∙ Y, then % Δ Z ≈ % ΔX + % ΔY If Z = X ∙ Y, then % Δ Z ≈ % ΔX + % ΔY • Applying this rule to the equation of total output %Total output %Productivi ty %Average hours %LFPR %Population 7 Economic Growth • What matters for a rising standard of living is real GDP per capita (i.e. per person) Since - Total output = Productivity x Average Hours x LFPR x Population Then - Output per capita = Total output ÷ Population Output per capita = Productivity x Average Hours x LFPR In terms of percentage growth rates %Output per capita %Productivi ty %Average hours %LFPR 8 Economic Growth • A tendency in most developed countries is that average hours of labor are slowly decreasing So our last simplification is to ignore changes in average hours in the equation % Δ Output per person ≈ % Δ productivity + % Δ LFPR 9 Growth in the Labor Force Participation Rate (LFPR) Recall that LFPR Labor Force Population So, %LFPR %Labor force - %Population 10 Growth in the Labor Force Participation Rate (LFPR) • Currently, U.S. Bureau of Labor Statistics predicts the employment growth rate to be 1% per year until 2010, about the same as the growth rate of population – If so, the % Δ LFPR ≈ % Δ Labor force - % Δ Population = 0 – Is there anything we can do to make the labor force grow faster than population, and thus increase the rate of economic growth? • Yes Increase labor supply Increase labor demand 11 Figure 1: An Increase in Labor Supply 12 Figure 2: An Increase in Labor Demand 13 Figure 3: The U.S. Labor Market Over A Century Real Hourly Wage S S L1 L2 B W2 W1 A D L2 D L1 L1 L2 Millions of Workers 14 How To Increase Employment • Supply side – Cut income tax • Paying 40% of one’s income as taxes (federal, state, and local) discourages work effort in the United States. • Tax cut would provide incentives to people to seek jobs • Labor supply curve shifts rightward – Changes in government transfer programs • Reduce social benefits 15 How To Increase Employment • Demand side – Government policies that help increase skills of the workforce or that subsidize employment • government-sponsored training programs • aid to college students • employment subsidies to firms 16 Growth in Productivity • Recently, virtually all growth in the average standard of living can be attributed to growth in productivity • What can we do to make productivity grow? 17 Figure 4: Capital Accumulation and Labor Productivity 18 Growth in the Capital Stock • One key to productivity growth is growth in nation’s capital stock – With more capital, a given number of workers can produce more output than before • Growth in capital stock will increase productivity as long as it increases amount of capital per worker Since capital per worker Total capital stock , Labor force % capital per worker % Total capital stock - % Labor force 19 Investment and the Capital Stock • A stock variable measures a quantity at a moment in time – Capital stock is a measure of total plant and equipment in economy at any moment • A flow variable measures a process that takes places over a period of time – Planned investment is a flow variable • Depreciation is decrease in the value of assets – As long as investment is greater than depreciation, total stock of capital will rise – The greater the flow of investment, the faster will be the rise in capital stock 20 Targeting Businesses – Demand Side Reducing business taxes • Corporate profits tax – A cut in tax on profits earned by corporations • Investment tax credit – A cut in taxes for firms that invest in certain favored types of capital • Reducing business taxes or providing specific investment incentives can shift the investment curve (the demand curve in the loanable funds market) rightward 21 Figure 5: An Increase In Investment Spending 22 Targeting Households – Supply Side • If households decide to save more of their incomes at any given interest rate – Supply of loanable funds curve will shift rightward • What might induce households to increase their saving? – – – – – Greater uncertainty about economic future Increase in life expectancy Anticipation of an earlier retirement Change in tastes toward big-ticket items Change in attitude about saving • Any of these changes—if they occurred in many households simultaneously— would shift saving curve to the right • What can government do to increase household saving? – One often-proposed idea is to decrease capital gains tax 23 Figure 6: An Increase In Savings 24 Government’s Budget Deficit • A increase in government purchases tends to raise interest rates • High interest rates discourage business investments So, to induce businesses to invest more, government should reduce its purchases –Shrinking deficit or rising surplus tends to reduce interest rates and increase investment –However, the effect on economic growth depends on how the budget changes 25 Figure 7: Deficit Reduction and Investment Spending Interest Rate 5% Supply of Funds (Saving) E A B 3% Investment Investment Spending Spending + Deficit 1.0 1.5 1.75 Funds ($ Trillions) 26 Human Capital and Economic Growth • Human capital – Skills and knowledge possessed by workers • An increase in human capital works like an increase in physical capital to increase output – Causes production function to shift upward • Raises productivity and increases average standard of living • Human capital investments – Education 27 Technology and Economic Growth • Another source of growth is technological change – Invention or discovery of new inputs, new outputs, or new methods of production • New technology affects economy in much the same way as do increases in capital stock – Shifts production function upward • Since it enables any given number of workers to produce more output • Investments in technology – R&D 28